I’m Retiring at the End of This Year and Will Have an Extra $40K to Invest. Should I Pay Off My Car Loan or Buy Dividend Stocks?

I will be retiring at the end of this year. I am trying to decide between two choices on how to best use $40,000 that I anticipate I will have as extra money by the end of the year. My only debt is the payoff of one automobile, which is about $40,000. Or, I can use the $40,000 to buy more dividend-paying stocks to add to my portfolio. My dividend portfolio will eventually pay off the car loan and the dividends will keep going on, whereas if I pay off the loan, I won’t have the extra dividends going forward.

-Chris

I see two points of discussion here. The first is the decision of whether to pay off debt or invest. It’s a classic problem but I’ll point out some things I would consider in your case. Next, you’ll want to examine whether dividend investing is the best option for producing retirement income. (And if you need help making important financial decisions, like investing or paying off debt, consider working with a financial advisor.)

Investing vs. Paying Off Debt

Comparing the interest rate on your auto loan to what you expect to earn on your investment is the most common way to approach the question of whether to pay off your debt early or invest the extra money. That’s usually where I start, too.

The lower your interest rate, the more sense it makes to invest the money. For example, if your car loan has a 2% interest rate, your investments may easily generate a higher return, making investing the better choice.

But what if your car loan has a 15% interest rate? You’re likely much better off getting rid of that debt. Obviously, most vehicle loan rates will fall between those two extremes.

When making this decision it’s also important to keep volatility in mind. In most cases, the interest you save by paying off debt is fixed and guaranteed. In other words, you know what you’ll be saving. On the other hand, investment returns can often be quite volatile. Due to the possibility of low or even negative returns in a given year, it may take several years for your investment returns to surpass the money you would save by paying off your debt. (And if you need more help with your financial plan, consider working with a financial advisor.)

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However, it’s not all about the math. Don’t forget to consider your own preferences, risk tolerance and budgetary considerations. Additionally, here are some equally important thoughts to mull over:

• If you pay off a debt, the erased payment is immediately available in your cash flow. With an investment, you have a time horizon and volatility to consider.

• For many, there is significant psychological or emotional benefits to paying off debt.

Dividend Investing for Retirement Income

Since we haven’t met, I’m not sure how much you’ve scrutinized the idea of dividend investing for retirement income. You may have researched it thoroughly and are perfectly comfortable with this strategy. If you haven’t, it’s important to point out some of the common misunderstandings of dividend investing. To be clear, I do not encourage retirees to rely on dividends due to several shortcomings:

• Dividends aren’t anything extra. They are an integral part of a stock’s total return. Spending dividends means reducing forward growth.

• They are inefficient both in terms of taxation and cash flow. When your portfolio is centered on dividends you hinder your ability to plan your tax liabilities and cash flows.

• Companies that pay large dividends are often very similar. These companies share very similar characteristics with one another. When your portfolio is loaded up with dividend stocks you are likely to be far less diversified than you should be.

• Dividends aren’t guaranteed. Companies must have earnings to pay dividends, which they can stop.

Dividends aren’t bad and I’m not suggesting that you should avoid dividend stocks entirely. I just think there’s less to the strategy than what the common story often suggests. (And if you need help finding financial advice, this tool can help match you with potential advisors.)

Bottom Line

Compare the interest rate on your auto loan and the return you’d expect on your investments. Also consider your time horizon, risk tolerance and the effects on your budget. As for dividend investing, I’d encourage you to take a critical look at that approach.

Tips for Finding a Financial Advisor

• Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have free introductory calls with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• Consider a few advisors before settling on one. It’s important to make sure you find someone you trust to manage your money. As you consider your options, these are the questions you should ask an advisor to ensure you make the right choice.

Brandon Renfro, CFP®, is a SmartAsset financial planning columnist and answers reader questions on personal finance and tax topics. Got a question you’d like answered? Email [email protected] and your question may be answered in a future column.

Please note that Brandon is not a participant in the SmartAdvisor Match platform, and he has been compensated for this article.

Photo credit: ©iStock.com/ChayTee, ©iStock.com/mapodile

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